Chapter 9, Problem 9.2P

a)

Summary Introduction

To compute: The net proceeds.

Introduction:

Flotation cost includes two components the underwriting charges and brokerage fees. The flotation cost helps to reduce the total proceeds received by the firm. Total proceeds would be paid from the bond funds. The flotation cost is the difference between the total proceeds and net proceeds.

b)

Summary Introduction

To determine: The cash flows over the maturity of bonds.

Introduction:

Every firm requires capital to fund their long-term investments. The typical sources of capital for a firm include debt and equity. Firms often raise their capital by selling securities such as common stock, preferred stock, and bonds to investors and also by reinvesting profits back to the firm. The capital structure of a firm is the mixture of debt and equity financing employed by the firm.

c)

Summary Introduction

To calculate: The before-tax and after-tax cost of debt.

Introduction:

The before-tax cost of debt refers to the rate of return that the firm should pay on new borrowing. The before-tax cost of debt of a firm would be equal to the required rate of return by the bondholders if the flotation cost is zero. .

${\text{r}}_{\text{i}}={\text{r}}_{\text{d}}\times \left(\text{1}-\text{T}\right)$

d)

Summary Introduction

To calculate: The before-tax and after-tax cost of debt using approximation formula.

Introduction:

The before-tax cost debt is the rate of return the firm must pay on a new borrowing. The after-tax cost of a debt is the cost after deducting the tax amount.

e)

Summary Introduction

To discuss: The comparison between the two approaches.

Introduction:

The before-tax cost of debt refers to the rate of return that the firm should pay on new borrowing. The after-tax cost of a debt is the cost after deducting the tax amount.

When after-tax cost of the debt is r_i and r_d is the before-tax cost of a debt, with the tax rate of the firm T, the before-tax cost can be converted to after-tax cost by using the following equation,

${\text{r}}_{\text{i}}={\text{r}}_{\text{d}}\times \left(\text{1}-\text{T}\right)$